The People's Bank of China governor says that the US dollar should be replaced as the world's reserve currency. Colin Teese reports.

Who would ever have believed it - China telling the US how to fix the mistakes that free-market economics has visited upon the world? And on the eve of the G20 summit!

How does this come about? For a start, China is crucial to America's economic recovery. According to the New York-based Council for Foreign Relations, unless China takes up about 30 per cent of US borrowings, President Barack Obama's stimulus package won't fly.

Chinese monetary authorities believe that the US, as compared with China, wasn't quick or effective enough in dealing with its problems. Nevertheless, self-interest demands that China support the US bail-out financially - not that Beijing is about to offer any blank cheques.

China is concerned about the role of the US dollar as the world's reserve currency. The Bretton Woods Conference conferred this role on the dollar in 1944. Whether that arrangement can continue is debatable.

Bretton Woods was an agreement for the times. In the context of the US's then economic clout and Europe's devastation from World War II, it made both economic and political sense. Effectively, it created and sustained what came to be known as the "West".

At the end of the war, the US as the most powerful economy on earth was the natural leader of the West. At Bretton Woods, the US agreed, among other things, to underwrite the West's trading and payments system.

Only the US could do this, and in return it demanded and obtained guiding control over the postwar institutions spawned by Bretton Woods - notably, the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT).

In establishing the dollar as a reserve currency, the US created what was, in effect, a gold standard for its Western partners. The US dollar - strong and reliable - became the principal currency unit for the conduct of international trade. Nations holding their foreign currency reserves in US dollars were guaranteed by the US that their reserves could be exchanged for equivalent amounts of gold, on demand.

It was a better system than the previous discredited gold standard which had the defect of limiting trade exchanges to the value of the world's supply of gold. Under the US arrangement, none of this applied.

The world was much simpler then, both politically and economically. For example, by the late 1960s, the GATT accommodated 68 countries, compared with about 130 in its successor, the World Trade Organisation (WTO), today.

The other big advantage was that Western economies could keep their currencies to a more or less fixed value against the US dollar. Thus the possibility of currency speculation was largely contained. Financial flows could be, and were, devoted to investment in new productive capacities, and to the financing of international trade.

Under these influences, Western prosperity became both widespread and enduring. But the tie to gold ended in 1971, when - because of financial instabilities introduced into the US economy following its excessive spending on the Vietnam War - the US could no longer guarantee gold for dollars.

Nobody said so at the time, but the setback opened a serious fault-line in the postwar economic order established at Bretton Woods that has never been repaired.

The IMF could no longer proceed with its efforts to manage international finances on the basis of fixed exchange-rate relativities among the Western economies. And the consequent floating of most of the West's currencies led to a push for wider financial deregulation.

Whereas previously, Western nations had mostly controlled financial flows, now Wall Street was pressing for opportunities to trade in the now fluctuating currencies.

A wider-ranging free market philosophy also gathered strength. The constraining influence of trade policies aligned with national interest gave way to an almost total commitment to free trade.

This blind faith in the virtues of unfettered markets was largely US-driven. It believed - misguidedly, as it turned out - that the new policy approaches best served US interests.

The growth of China as a successful practitioner of state capitalism became an economic and political force on the back of these policies. As a result, a division was built into the world trading system, creating saving and spending economies.

Imbalances

The savers, like China, made and sold things to spenders like the US, and then lent them the money to buy their consumer imports. These imbalances have largely created and perpetuated the present financial crisis and its flow-on effect in the world's real economy.

The US has been slow to recognise this connection - as apparently has our own Prime Minister Kevin Rudd. Not so the Chinese, who have gone public on it - and, even more remarkable, they have, against their own interest, pointed out this connection to the Americans.

People's Bank of China governor Zhou Xiaochuan has recognised this. As reported recently in the Australian Financial Review, Zhou outlines the dilemma facing US financial authorities in managing a reserve currency. On the one hand, they need to control the US money supply to manage domestic inflation, and on the other they must meet other countries' needs for the reserve currency.

Elaborating, Zhou said, "They may either fail to adequately meet the demands of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in global markets by overly stimulating domestic demand."

It may be assumed that Zhou is reflecting Beijing's view when he says that, over time, the US dollar should be replaced as a reserve currency by a form of special drawing rights (SDRs) conceived and managed within a newly constructed IMF.

Zhou was perhaps too diplomatic to say so, but quite obviously, he assumes the new institution would be controlled according to the weight of contribution of SDRs by individual countries. China would, of course, be a major contributor.

The interesting aspect of Zhou's observations is that, inadvertently, it gives us an accurate picture of how we got into the present financial mess. In essence, the problem arises from the fact that the US is finding it impossible - perhaps for reasons beyond its control - to have the dollar continue as the world's reserve currency.

It may be that the world has grown beyond the point where it is possible for any single country, even one as powerful as the US, to back a reserve currency to the world. President Obama and our own Prime Minister Rudd aren't conceding this point, but the facts of what's happened cannot be denied.

It is also true that if the US says it needs China to shoulder 30 per cent of America's debt to fix up the mess, then the Chinese are certainly going to demand a say on how it is done. What they seem to be saying is, "If you want our money, a condition is that that we, together, in our own collective interest, need to address all the problems - including that of the reserve currency."

It is possible that the comments by Obama and Rudd before the G20 meeting are necessary for immediate political purposes - and that they privately acknowledge that the reserve currency is a problem that will have to be addressed.

All things considered, something like what Zhou suggests might not be a bad idea. No doubt the Chinese would be looking for more than their justifiable share of control, but so would a great many more; all of that would have to be settled in negotiation. Certainly, the outcome would be different from Bretton Woods where the US got most of the say because it was putting up most of the money.

In any new scheme based on SDRs contributed to an IMF-managed fund, there would be a number of significant contributors. The US would be the biggest, much bigger than China. Japan would be another. There would be many more.

China might have a big say, but it would not dominate it in the way the US did with Bretton Woods.

The detail of any new arrangement would be difficult to work out and may take some years. Bretton Woods certainly did. Meanwhile, something provisional might need to be arranged to tide us over.

But any recasting of the IMF need not begin and end with its taking over the role of reserve currency. It might be wise and quite possible for it to become the sole banker for international trade flows. After all, trade is worth about US$10 trillion, compared with about US$90 trillion for world GDP.

But inter-firm trade accounts for much of international trade, and this need not qualify for IMF funding.

As to the IMF's present functions associated with funding and managing troubled economies, that might be better handled by another body - perhaps a reshaped World Bank.

The present IMF has not handled this function well in recent times - certainly not since it became driven by the free-market ideology associated with the Washington Consensus. Since the far-reaching east Asian financial crisis of 1997-98, IMF influence has been much diminished and its reputation tarnished.

This kind of overhaul of international financial arrangements, however difficult, might prove more enduring and beneficial than any newly conceived framework of financial regulation. It could, however, expect to meet with strong opposition from Wall Street. That may well prove to be the most troublesome obstacle of all.

Any new arrangement for trade-financing would also bring in its wake a need for a major reshaping of the WTO to bring that institution into realistic relationship with emerging trade practices. But that's another story.

- Colin Teese is a former deputy secretary of the Department of Trade.

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Bretton Woods left a legacy the G20 leaders can only dream of

While the Bretton Woods agreement laid the foundations for the greatest economic boom in history, many experts argue that the G20 has produced only a limp, over-hyped response to the global downturn.

Bretton Woods, of course, belonged to a simpler, more austere, more serious age. And its major players were some of the world's finest economic minds - thoughtful, accomplished men, little known to the public or the media.

In 1944, they gathered in a remote country hotel in a snowbound corner of New England, far from the blinding glare of international publicity. And they were hard at work for a full three weeks - a very different story from the pitiful 24 hours that world leaders set aside for last week's jamboree.

Bretton Woods was that rare thing: a summit that genuinely changed the course of history. That it succeeded so well was a tribute not to grandstanding or to spin and public relations, but to the sheer hard work and expertise of its participants.

Indeed, the decisions set the scene for the extraordinary growth of the Fifties and Sixties, arguably the most golden economic age in history.